Tuesday, June 12, 2007

"It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone - after deducting all prior claims, and counting as zero the fixed and other assets - the results should be quite satisfactory."

-Ben Graham

Ben Graham, the most legendary value investor of all-time, was the first to bring forth the notion that it was prudent for investors to purchase securities that brought with them a margin of safety. One way Graham defined this concept was through his Net Current Asset Value calculation. Here, Graham believed there was a potential margin of safety in companies whose current market value was less than 2/3 of their NCAV, defined as:

Note that the margin of safety came on two fronts, reflected in the conservative nature of this formula. First, any long-term assets, such as property plant and equipment were not considered in the calculation, yet all liabilities were included. Second, Graham’s application of 2/3 to this formula also placed a large discount to the value of the company. The effect of the two can be a powerful combination, having a potentially geometric effect on the size of the discount, depending on the company, and its structure. Essentially, by purchasing a net/net, you are theoretically getting the long-term assets for free- assuming there’s any value to those assets.

For the most part, this technique has been long forgotten, and is no longer utilized in practice. Perhaps the major reason being that it has been difficult in recent years to identify many companies trading at less than 2/3 NCAV. However, with a slight adjustment to Graham’s formula, the concept lives on, and at times is a potentially profitable way to generate alpha.

The History

In my work in helping to build and manage the Equity Fundamental Database of a major market data provider in the 1990’s, I began to experiment with Graham’s formula, and quickly discovered that by dropping the “2/3” factor from the formula, and screening for companies trading below 1 times their net current asset value, I could generate a reasonably long list of US companies. Most if not all were typically deep into the microcap space; many were on this list for a very good reason. Companies that appear to be cheap may be well on their way to bankruptcy. The trick is to try and distinguish between the “cigar butts” as Ben Graham referred to them, and the companies that have some true value, that will ultimately be recognized by the markets.

My research resulted in a few published articles on the subject, and interestingly enough, a segment on a call in radio show in 2002. Still, other than a notable mention in the excellent Tweedy Browne report “What Has Worked in Investing”, (which referenced perhaps one of the last studies done on the subject- Professor Joseph Vu from DePaul, 1988), the topic has remained on the fringe of investment techniques.

When I started the Cheap Stocks site in 2003, I focused primarily on net/nets. This was at a time when there were a few hundred companies trading below their net current asset value, as the markets began to awake following the bursting of the tech bubble. This is not atypical. When there is a bull market in equities, the rising tide lifts all boats, and subsequently, the ranks of net/nets shrink considerably. That is certainly the current state of the net/net market. Currently, there are less than 80 such companies, with an average market cap of TK: very slim pickings in terms of legitimate candidates. (See appendix for a current list)

The Study

Starting with a list of net/nets as of February, 2003, I reviewed the top 50 in order of market cap, in order to evaluate returns in the subsequent four years. The results surpassed my expectations. The average annual return was 22.29%; the average cumulative return for the four year period was 117 percent. The market caps of the 100 ranged from a high of almost $1.4 billion (Circuit City), down to 69 million, with an average of $158 million. Not exactly an institutional investors dream in terms of liquidity and company size, but potentially profitable for some investors. Of the 100, 10 companies were acquired sometime within the four year period.

Words of Caution

No research piece on net/nets is complete without a discussion of the risks inherent in investing in such securities. Often, these companies are cheap for very good reasons. Some are a few quarters away from bankruptcy. Others may show up in a stock screen due to quarterly balance sheet data which lags a recent fall in price. In these situations, the market cap may have dropped off considerably due to a recent event, but the fundamental data utilized in the net/net calculation is up to three months old. Once the new 10q OR 10k is released, it becomes very evident that there has been a degradation in the company’s balance sheet, and the company is not a net/net after all.

Liquidity Issues

Furthermore, when dealing with micro caps, liquidity is often an issue. Companies may trade infrequently, and have very wide bid/ask spreads. When evaluating such companies, it is imperative to be aware of daily trading volume, and the spread. Placing a market order can be very dangerous, so limit orders should be considered.

Asset Quality

The composition and quality of a company's current assets is also an important factor in assessing an individual net/net. All else being equal, the greater the amount of cash and marketable securities as a percentage of current assets, the better. In terms of true value, it goes downhill quickly for the other current asset accounts. Accounts receivable, for instance, must be collected in order for value to be realized, and there are no guarantees this will happen. Inventories may be worth pennies on the dollar if they needed to be quickly converted into cash, plus there are storage and maintenance costs. Cash, on the other hand, has a fixed value. What you see is what you get.

Conclusion

While now may not be the best time in terms of identifying net/nets, the study does raise an interesting point. While it is always prudent to evaluate net/nets individually, it may also be rewarding to assemble a portfolio of such companies, essentially an index, without a great deal of individual scrutiny, when there are enough available to make such an endeavor feasible. Given current market conditions, and the small number of available net/nets, it is more prudent to evaluate single security candidates in order to determine investment merit, than to blindly buy, say the top 20 sight unseen.

The ListIf you are interested in obtaining the list of 2003 net/nets referred to in this piece, please e-mail us.